How the Debt-Ceiling Showdown Could Affect You

As Congress lurches about in search of a deal to raise the nation's debt ceiling before an August 2 deadline, ordinary investors are watching anxiously to see whether there'll be a repeat of September 29, 2008.

That's when lawmakers in the House of Representatives defied the Federal Reserve chief's warnings, as the financial crisis was exploding, and rejected a Bush administration bank-bailout plan, objecting to such an expensive big-government intrusion into the private sector. That sent the Dow Jones stock index plunging 778 points in a single day.

As they were then, the retirement savings of ordinary Americans are at risk if Congress misses the debt-limit deadline. If it does, the government won't be able to fully cover its debts, which would cause the first default in US history, risk panicking financial markets, send interest rates soaring and kick the economy into renewed recession.

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Most analysts still bet on an eleventh-hour compromise, but the question is whether big institutional investors will wait patiently for a last-minute deal or move before then by demanding higher rates for purchasing US debt. That could force the hand of lawmakers and erode billions, if not trillions, in retirement wealth in the process.

Credit rating agencies Moody's Investors Service and Standard & Poor's put the US government on notice earlier this month that it could soon lose its vaunted AAA rating for US government bonds. One smaller agency, Haverford, Pennsylvania-based Egan-Jones Ratings Co, announced Monday that it had downgraded US debt to AA-plus.

Should the larger, more influential rating agencies downgrade US debt, that alone would reverberate through an already weak US economy. It would prompt investors to demand a higher interest-rate return, called a yield, for buying US bonds. That would worsen the already problematic federal debt situation, because the United States borrows 40 cents of every dollar it spends. The government then would have to pay even more to borrow, falling deeper in debt.

Rising yields on government bonds would drive up the costs of all bonds, forcing corporations to pay investors higher yields to hold their bonds, and ditto for municipal governments. Money that otherwise would go to shareholders or into job creation would go to creditors.

Money markets also could be adversely affected.

So what's an average Joe or Jane to do? Get out of stocks until the debt-ceiling showdown is resolved? Get into bonds? Put savings under the mattress?

Most investment advisers say to stay the course, with a caveat.

“Reaction to these kinds of market events is typically not a very productive approach. Many people who got out during the financial crisis didn't know quite when to get back in and missed the entire run-up” since April 2009, said Brian Reid, the chief economist for the Investment Company Institute, the trade association for large mutual funds and other investment funds.

“Whatever happens here is going to be over and done with, and people who would have bought or sold into that period of uncertainty would likely lock in losses and hurt themselves in their 401(k) plan.”

Investment Company Institute data show that there's been a steady move out of stock funds over the past four years. Many ordinary investors are putting their retirement assets into target funds, which diversify investments based on the number of years until retirement.

Retirement assets totaled about $18 trillion as of the end of March, with about $9.6 trillion of that in 401(k) plans and individual retirement accounts. That's just under the all-time high of $18.1 trillion in retirement funds at the end of September 2007, Reid said.

Analysts advise against putting all your nest eggs into one basket.

“We continue to preach the benefits of diversification among and within asset classes, both domestic and international,” Liz Ann Sonders, the chief investment strategist for Charles Schwab & Co, wrote Monday.

As the ever-bullish chief investment strategist for Wells Capital Management in Minneapolis, Jim Paulsen advises investors to look past the debt-ceiling theatrics.

“The debt ceiling to me is way down the list. I don't think that's a big risk, and I think investors should largely ignore it. It's a self-imposed limit and it wasn't imposed by an outside law, regulatory body or rating agency or anything, and it's made to increase over time,” he said. “It's been done in the past and it will be done again.”

Paulsen is more optimistic than most that the US economy will accelerate sharply in the second half of this year, lifting spirits along with retirement plans.

Yet there's still a huge potential risk. If lawmakers fail to reach a deal, things could get ugly fast. It happened on September 29, 2008. The Dow lost more than 7 percent of its value on the day that House Republicans led the defeat of President George W. Bush's initial Troubled Asset Relief Program, now known as the bank bailout. Lawmakers reversed themselves four days later, but deep damage had been done.

“That was the catalyst for the Great Recession. We were losing 750,000 jobs a month just a few months later,” said Mark Zandi, the chief economist for forecaster Moody's Analytics. “This was a catalyst for a complete washout in sentiment. Things were already falling apart when this happened. There was just nothing to break the free fall.”

Today, the economy is not in recession, it's in a recovery, albeit a weak one. Corporate profits are soaring, and manufacturing and exports are growing. There's forward momentum.

However, that's being slowed by the protracted debate over raising the debt ceiling, with some lawmakers even suggesting that a short debt default would be OK. It's fostered growing uncertainty in financial markets. Yields on the bellwether 30-year Treasury bond have been rising, and the cost of buying default insurance against US bonds has risen 20 percent since April. The political strife has hurt confidence, weighing on business and consumer sentiment.

“This goes to the war in Washington over the debt ceiling. … Each day that goes by, the financial markets grow more worried,” Zandi said.

Sonders, the Charles Schwab strategist, doesn't expect that a worst-case scenario will happen, but she can envision one.

“A worst-case scenario would have Treasury yields rising significantly, bringing other yields up alongside, representing a material tightening of financial conditions in less-than-perfect economic times. The dollar would likely drop, as would stocks — perhaps meaningfully so,” she wrote.

There's no modern precedent for the world's largest economy defaulting on its debt. The closest guide from history, Sonders noted, is a ratings downgrade in May 1998 to several European countries — countries that, incidentally, are now in trouble again. Bond yields rose only slightly and then fell a month later; one year later they were a full percentage point lower. Similarly, Japan suffered a ratings downgrade in February 2001, but bond yields remained largely flat.

The difference between those countries and the United States is that the dollar is the world's reserve currency and Treasury bonds often are used as collateral in all sorts of investment and business deals.

“Violating the debt ceiling would scare the capital markets, force at least a temporary credit downgrade to 'default' and it would potentially permanently damage the safe haven and reserve currency status of the dollar,” Ethan Harris, the chief North America economist for Bank of America Merrill Lynch, warned July 15 in an analysis.

© 2011 McClatchy-Tribune Information Services

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